Unit – 3

Production, Cost and Revenue

 Factors of production
▪ Resources used for the production of a product are known as
factors of production.
▪ Factors of production are termed as inputs (land, labour, capital,
organisation).
▪ Output refers to the commodity produced by various inputs.
 Production function
▪ Factors of production (L,L,C,E) are commonly aggregated into 2
basic factors of capital (K), and labour (L), so that in general:
✔ Q=f(K,L)
 Types of production function
▪ Short-run production function
✔ In the short-run, production function may be rigid.
✔ Short run production function is, where at least one factor of production
is fixed.
▪ Long-run production function
✔ In long-run, production function is flexible.
✔ In LR, all inputs are variable.
 1. The Law of Variable Proportions
▪ If one input is variable and all other inputs are fixed the firm’s
production function exhibits the law of variable proportions.
▪ If the number of units of a variable factor is increased, keeping
other factors constant, how output changes is the concern of the
law.
▪ Suppose land, plant and equipment are the fixed factors, and
labour the variable factor.
▪ This principle can be defined thus: When more and more units of
the variable factor are used, holding the quantities of a fixed factor
constant, a point is reached beyond which the marginal product,
then the average and finally the total product will diminish.
▪ The law of variable proportions is also known as the law of
diminishing returns.
▪ Assumptions
✔ Only one factor is variable while others are held constant.
✔ All units of the variable factor are homogeneous.
✔ There is no change in technology.
✔ It assumes a short-run.
 The Law
▪ The fixed factor (input) land of 4 acres, units of the variable factor
labour are employed and the resultant output is obtained.
▪ The total, average and marginal products increase first, reach
maximum and then start declining.
▪ The total product reaches its maximum when 7 units of labour are
used and then it declines.
▪ The average product continues to rise till the 4th unit while the
marginal product reaches the maximum at the 3rd unit of labour,
then it falls.
▪ The marginal product starts declining first, then the average
product and finally total product falls.
▪ The TP curve first rises at an increasing rate up to point A (inflection
point) and then total product increases at a diminishing rate till it
reaches the maximum at C and then its starts falling.
▪ MP curve reaches the maximum at D and AP curve is maximum at
point E where it coincides with MP curve.
▪ When TP curve reaches its maximum C, the MP curve becomes
zero at point F.
▪ When TP starts declining, the MP curve becomes negative i.e., its
below X-axis.
 Stages of the Law of Variable Proportions
Stage I: Increasing Returns
▪ TP, AP and MP are increasing
▪ When more workers (variable factor) are employed to fixed piece
of land production increases rapidly.
▪ In this stage, land is too much in relation to the workers employed.
▪ It is, therefore, uneconomical to cultivate land in this stage.
Stage II: Diminishing returns
▪ Here, land is scarce and is used intensively. More and more
workers are employed in order to have larger output.
▪ The total product increases at a diminishing rate and the average
and marginal product decline.
▪ Throughout this stage, the marginal product is below the average
product.
▪ This is the only stage in which production is feasible and profitable.
Stage III: Negative marginal returns
▪ The employment of the 8th worker actually causes a decrease in
total output from 60 to 56 units and makes the marginal product
minus 4.
▪ Here the workers are too many in relation to the available land,
making it absolutely impossible to cultivate it.
▪ In this stage, total product starts declining and the marginal
product becomes negative.
▪ Production cannot take place in Stage III.
 Best Stage of Production
▪ Production will always take place in stage II.
▪ Thus the stage of diminishing returns is the optimum and the best
stage of production.
▪ Hence, the law of variable proportions is otherwise called as the
law of diminishing returns.
 2. The Law of Returns to Scale
▪ To meet a long-run change in demand, the firm increases its scale
of production by using more space, more machines and labourers
in the factory.
▪ The law of returns to scale describes the relationship between
outputs and the scale of inputs in the long-run when all the inputs
are increased in the same proportion.
 Assumptions
▪ All factors (inputs) are variable but enterprise is fixed.
▪ No change in technology.
▪ In the figure, RS is the returns
to scale curve where from R
to C returns are increasing,
from C to D, they are constant
and from D onwards they are
diminishing.
Increasing returns to scale (IRS)
▪ Increase in total output is more than proportionate to the increase
in all inputs (specialisation & division of labour; economies of scale)
Constant returns to scale (CRS)
▪ Increase in total output is proportionate to the increase in inputs.
Diminishing returns to scale (DRS)
▪ Increase in output is less than proportionate to the increase in
inputs. (problems of supervision, mgt, increase in factor prices, raw
materials, transportation, marketing – diseconomies of scale).
▪ When the scale of production is doubled and trebled the total
returns are more than doubled i.e, 17 and more than three-fold
i.e., 27. It shows increasing returns to scale.
▪ When the scale of production is increased i.e., 4th and 5th units of
scale of production, marginal returns are 11 i.e., returns to scale
are constant.
▪ Increase in the scale of production beyond this i.e., 6th, 7th and 8th
units, will lead to diminishing returns. Total returns increase at a
diminishing rate & marginal returns start diminishing.
 Isoquants
▪ An isoquant is a curve on which the various combinations of labour and
capital show the same output.
▪ According to Cohen and Cyert, “An isoproduct curve is a curve along which
the maximum achievable rate of production is constant”.
▪ The firm can produce 100
units of output at points
A,B,C and D with different
combinations of labour and
capital.
▪ Connect points A, B, C and D
to have Isoquant IQ.
 Properties of Isoquants
▪ Isoquants slope downwards from left to right.
▪ Isoquants are convex to the origin.
▪ Two isoquants never intersect each other.
▪ Higher isoquants represents higher level of output.
▪ No isoquants can touch either axis.
▪ Isoquants need not be parallel to each other.
 Cost of production
▪ Total amount of money spent on the production of a commodity.
Management use of cost concept
▪ To fix price
▪ Investment decision
▪ Profit
 Types of cost
1. Explicit cost
▪ It refers to actual payment made during the course of running a
business, such as wages, rent, interest, raw materials etc.
2. Implicit cost
▪ Implicit cost is where no actual payment is made.
▪ These are imputed value of the entrepreneur’s own resources and
services.
▪ Eg: Salary of the owner-manager who does not receive any salary
▪ Eg: Estimated rent of the office building owned by the entrepreneur
▪ Eg: Interest on own capital invested by the entrepreneur
▪ Economists’ cost - Implicit cost + Explicit cost
▪ Accountants’ cost - Explicit cost
3. Opportunity cost or alternative cost
▪ It is the opportunity lost or the costs of displaced alternatives.
▪ Opportunity cost of any good is the next best alternative good that
is sacrificed.
▪ It represents sacrificed alternatives; hence it is not recorded in
account books.
▪ It is due to scarcity of resources.
▪ Eg: Set of factors that can be used to produce guns / wrist watches
4. Sunk cost
A sunk cost refers to money that has already been spent and
which cannot be recovered.
Eg: Depreciation, money spent on machinery, equipment, rent,
marketing etc.
5. Private cost
Private costs are those costs incurred by a firm in producing a
commodity.
Eg: Expenses in purchasing capital equipment, hiring labor, and buy
raw materials or other inputs.
6. Social cost
▪ Production activities of a firm may lead to social benefit (education,
sanitation services) or harm for others (social cost).
▪ Production of rubber, leather, chemicals etc., pollutes the
environment which leads to social costs.
7. Fixed cost
▪ Fixed costs do not vary with output produced or sold.
▪ Even if there is no production these costs have to be incurred.
▪ Fixed costs remain constant for a specific period.
▪ Fixed costs are incurred in the short run (for in long run all costs are
variable).
▪ It is also known as constant costs, supplementary costs or overhead costs.
▪ Eg: Monthly salaries to permanent staff, rent on office and factory buildings,
interest payments.
8. Variable cost
▪ Variable costs vary directly as output changes.
✔ VC = f(output); ↑output; ↑VC
Variable costs are also known as prime costs or direct costs.
Eg: Wages, raw materials, fuel, power, etc.
Short run – Distinction between FC and VC.
Long run – All costs are variable.
Total cost
▪ Total money expenses incurred to produce a commodity.
TC = TFC + TVC
▪ Where, TC → Total Cost; TFC →Total Fixed Cost; TVC →Total
Variable Cost
▪ TFC is horizontal as, whatever
be the output TFC is same.
▪ TVC starts from the origin i.e., if
output is 0, TVC is also zero.
▪ TC = TFC+TVC; so it starts from
y axis.
↑output; smaller the AFC.
AFC curve is a downward
sloping curve to right.
It is a rectangular
hyperbola.
AVC will be ‘U’ shaped curve.
AVC will fall as output increases up
to a normal capacity, but if output
is increased beyond that then AVC
will increase.
 Computation of Marginal Cost

Output Total Cost Marginal Cost

0 200 -
1 250 50
2 290 40
3 320 30
4 360 40
5 412 52
6 472 60
MC declines and then rises.
MC curve is ‘U’ shaped.
If there is increasing returns; MC declines (↑output; ↓cost).
If there is diminishing returns; MC increases (↑output; ↑cost).
MC changes due to changes in variable cost (↑VC; ↑MC and vice
versa)
MC is independent of FC.
 Cost – output relationship
Cost function
▪ The relation between cost and output is known as cost function.
Types of cost functions
(1) Short run cost function
(2) Long run cost function
 (1) Short run cost-output relationship
→ In short run, only some inputs are variable and other inputs are held
constant.
→ To increase or decrease output, the variable inputs have to be
increased or decreased.
1. AFC falls as output rises
2. AC first falls and then rises
3. AVC first falls and then rises
4. AVC rises before AC rises
5. MC cuts AVC and AC at their
minimum points
Long Run Average Cost Curves
SACs are plant curves.
LAC is called as Envelop curve.
LAC is ‘U’ shaped or rather it is boat
shaped.
LAC falls with increase in output,
reaches the minimum, and then rises.
OQ is the optimum output (the firm
produces more at lowest AC).
3. Marginal Revenue (AR)
▪ MR is the change in total revenue resulting from an increase in sale
by an additional unit of the product.

Units sold TR MR

1 10 -

2 14 4

3 19 5
(a) Revenue Curves of the firm under perfect competition

Units sold Price or AR (Rs.) TR (Rs.) MR (Rs.) Under perfect

1 5 5 5 competition (PC),

2 5 10 5 market price is

3 5 15 5 accepted. All units

are sold at same
4 5 20 5
price. Therefore, AR
5 5 25 5
= MR.
6 5 30 5
(b) Revenue Curves of the firm under imperfect competition

Units sold Price or AR (Rs.) TR (Rs.) MR (Rs.)

1 10 10 10

2 9 18 8

3 8 24 6

4 7 28 4

5 6 30 2

6 5 30 0
▪ Under imperfect competition, a firm
can sell larger quantities at low
price. Therefore, AR is downward
sloping like demand curve.
▪ MR declines faster than AR curve.
▪ MR is below AR
 Break Even Analysis
▪ Break-Even Point (BEP) is that level of sales where Total Revenue
(TR)=Total Cost (TC) i.e., TR=TC and the net income is zero.
▪ BEP is also known as no-profit; no-loss point.
Output (sales) P TR TFC TVC TC Profit/Loss
0 4 0 300 0 300 -
100 4 400 300 300 600 loss
200 4 800 300 600 900 loss
300 4 1200 300 900 1200 BEP
400 4 1600 300 1200 1500 profit
500 4 2000 300 1500 1800 profit
600 4 2400 300 1800 2100 profit
Thank You